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If Three's a Crowd, Thousands Are ... an Investment Round? JOBS Act Presents Significant Changes to the Federal Securities Laws

Corporate and Securities Law Alert

Authors: Robert A. Friedel and Odia Kagan

3/29/2012

The “Jumpstart Our Business Startups Act” (JOBS Act, or the act) was approved by both the House of Representatives and the Senate and is expected to be signed by the President and be enacted into law in the coming days. The stated purpose of the act is to increase job creation and economic growth by making it easier for private companies to raise capital, enabling a larger portion of the general public to invest in private companies and reducing securities laws reporting and registration requirements. Nevertheless, critics of the act, including the Securities and Exchange Commission (SEC), state securities regulators, institutional investors and investor protection groups, have expressed concern that the JOBS Act will harm investors by reducing transparency and investor protection.

General Solicitation or Advertising Permitted to Accredited Investors

The act answers the long-standing call from business groups to loosen the reins on the prohibition against general solicitation and advertising in private placements to accredited investors. Accredited investors include business entities with at least $5 million in assets and individuals with a net worth of at least $1 million (not including the individual’s primary residence) or an annual income in excess of $200,000 (or $300,000 together with the individual’s spouse). As accredited investors are considered to be better able to “fend for themselves” in evaluating the risks and merits of a proposed investment than are non-accredited investors, the securities laws have historically provided for more lenient rules for issuers offering securities to accredited investors.

Eased Disclosure Requirements for Emerging Growth Companies

The act creates a new category of companies, dubbed “emerging growth companies” – which captures most public companies – and reduces SEC disclosure requirements for these companies. Under the act, a company is considered an emerging growth company until the earliest to occur of the following:

  • the company achieves $1 billion in annual revenues
  • the company achieves $700 million in public equity float, has been an SEC reporting company for at least one year, and has filed at least one annual report with the SEC
  • the company has issued more than $1 billion in non-convertible debt during the past three years, or
  • at least five fiscal years have passed since the company’s IPO.

For emerging growth companies, the act rolls back some compensation disclosure requirements imposed by the Dodd-Frank Act, including the requirement to hold a “say-on-pay,” “say-on-frequency” and “say-on-golden parachute” shareholder advisory votes and the requirement to disclose the ratio of CEO compensation to the median compensation of all other employees. Emerging growth companies will also:

  • not be required to have their independent auditors audit the company’s internal controls for financial reporting, expanding the scope of this exemption that had previously been available only to smaller reporting companies
  • be permitted to freely engage in communications with potential institutional accredited investors to determine whether they have an interest in a contemplated securities offering (a “test-the-waters” communication)
  • be permitted to submit a draft securities offering registration statement to the SEC for confidential nonpublic review prior to public filing
  • be required to provide only two years of audited financial statements rather than three in registered public offerings, including IPOs
  • not be required to provide five years of audited “selected financial data” in public offering registration statements and annual reports
  • be permitted to provide the slimmed-down “scaled” compensation disclosure normally reserved to smaller reporting companies (i.e., less than $75 million in public float) in public offering registration statements and proxy statements
  • not be required to comply with any new or revised financial standards, unless the standards apply to nonpublic companies
  • not be subject to any future rules that require the company to periodically change its independent auditor firm, currently being contemplated by the Public Company Accounting Oversight Board (PCAOB) for every five or ten years.

In addition, the act exempts from registration requirements public offerings of up to $50 million in any 12-month period, a significant increase from the existing exemption under Regulation A of the Securities Act of 1933 applicable to offerings not in excess of $5 million. As with the existing regulation, the expanded exemption would permit “test-the-waters” communications with prospective investors and would not be available if the company or any of its directors, executive officers or promoters have a history of securities-related convictions or sanctions. The companies included in this expanded exemption would also be exempt from registration under state securities laws, if their securities are listed on a national securities exchange or are sold to certain qualified purchasers.

Existing rules designed to avoid research analyst conflicts of interest will not apply in connection with emerging growth company IPOs. Specifically, for emerging growth company IPOs, research analysts at an underwriting firm will not be restricted from participating in investor meetings or from publishing research reports before or soon after the IPO, or before the expiration of the IPO lock-up period.

Eased Registration Thresholds

The act eases the requirement for registration under the Securities Exchange Act of 1934 – by which a company becomes obligated to file periodic reports with the SEC – by increasing the threshold for registration. Whereas existing rules require registration by any company with total assets of $10 million and 500 or more holders of record of a class of the company’s equity securities, the act increases the threshold number of shareholders to 2,000 or more holders of record, or 500 or more holders of record who are not “accredited investors.” For bank holding companies, the threshold number of shareholders will be 2,000 or more holders of record. Shareholders who received their shares as employee compensation, such as through stock awards or stock options, prior to the time that the company becomes subject to SEC periodic reporting requirements, are excluded from the number of holders of record for purposes of the registration threshold, as are shareholders who acquire their shares through a “crowdfunding” offering, discussed below.

Crowdfunding

In a title dubbed the “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012” or “CrowdFund” act, the act creates a new way to raise capital, called “crowdfunding,” a term generally defined as “collective cooperation, attention and trust by people who network and pool their money and other resources together, usually via the Internet, to support efforts initiated by other people or organizations.”1 Private companies would be able to raise up to $1 million in any 12-month period, from small investors not meeting the income or net worth requirements of an “accredited investor,” through a broker or a funding portal registered with the SEC. The amounts invested by each investor are capped and vary in accordance with the investor’s financial status: up to $2,000 for an investor whose annual income or net worth is $40,000 or less, up to 5 percent of annual income or net worth if the investor’s annual income or net worth is greater than $40,000 and less than $100,000, and up to 10 percent of annual income or net worth up to a maximum of $100,000 if the investor’s annual income or net worth exceeds $100,000.

Issuers will be permitted to advertise their crowdfunding offering and solicit investments through any medium, including the Internet, so long as they direct potential investors to the broker’s or funding portal’s web site for the terms of the offering.

Investor Protections

In order to protect the new class of investors, who may not be well-versed in the investment process, the act imposes requirements including: disclosure of the risks associated with the investment, ensuring that the investors understand the risks associated with an investment in start-ups and emerging businesses including a potential loss of the entire investment and conducting background checks with respect to the company’s officers and directors as well as major shareholders.

Reduced Disclosure Obligations

Companies raising “crowdfunding” capital would need to comply with certain reduced reporting requirements, including providing information to the SEC and to the potential investors with respect to the companies’ directors, officers, substantial shareholders, operations and financial condition. Companies seeking to raise $100,000 or less would be required to provide tax returns and a financial statement certified by a company principal; those raising up to $500,000 would be required to provide financial statements that are reviewed by an independent public accountant; those raising more than $500,000 would be required to provide audited financial statements. Naturally, detailed information with respect to the offering would need to be provided, including the purpose and intended use of the proceeds, the target amount, the price of the securities offered, the type and attributes of the securities offered and risks associated with minority ownership in the company.

Following the offering, companies would need to update the investors at least annually with the results of operations and financial status. There are limitations on the sale or transfer of shares purchased pursuant to the crowdfunding exemption. They may not be sold for one year except for a sale back to the company; to an “accredited investor”; to a family member of the purchaser, in connection with the death or divorce of the purchaser; or as part of a registered securities offering.

Public companies, investment companies, private funds, and non-U.S. companies, would be ineligible for the exemption. Within nine months after the act is enacted, the SEC is directed to issue rules setting additional protections on investors, if necessary, and setting forth additional criteria as to companies and/or brokers who would be ineligible to take advantage of or participate in transactions pursuant to the crowdfunding exemption.

Offerings conducted pursuant to the crowdfunding exemption are exempted from the registration thresholds under the Securities Exchange Act of 1934 mentioned above as well as from registration requirements under state securities laws.

A Brave New Offering World?

Notwithstanding concerted objection from the SEC, state regulators, and some institutional shareholder groups, the act passed easily and with large majorities in both the House and the Senate and is being awaited with much anticipation by small companies and small investors alike. However, the provisions raise certain issues that will need to be addressed in the course of the coming months. One area of concern is whether the disclosure requirements imposed upon companies taking advantage of the crowdfunding exemption would be sufficient to protect amateur investors and what could be done in order to ensure such protection. For example: Would such investors understand the terms of an offering of preferred securities and the potential for their securities to be subordinated to future investments? How would the companies deal with future changes to the securities pursuant to an additional round? What can be done in cases of a “pay to play” where an additional investment would cause an investor to exceed his or her limit for a given year? How should companies best prepare to deal with solicitation of votes from the crowdfunding round? How can the disclosure information be provided, especially in an online format, in a manner that would be easily understood by investors? How will a company or its funding portal ensure, whether through online contracting or otherwise, that the investors read, understood and agreed to the terms? How will the funding portals safeguard the privacy of the investors transferring their information online?

Endnotes

1 http://en.wikipedia.org/wiki/Crowd_funding

Robert A. Friedel and Odia Kagan

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.